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Lower Debt Ratios Likely for Unsubsidized Green Energy

By Angus McCrone, Bloomberg New Energy Finance’s Chief Editor. This article first appeared in BNEF’s ‘New Energy Deals’ publication, available to clients on the web and on the Bloomberg Terminal.

The new era of unsubsidized wind and solar projects will mean developers facing a smaller pool of potential lenders, resulting in “a squeeze” on the debt ratios that they have enjoyed up to now, according to BNP Paribas.

The French bank, which is one of the largest providers of project finance debt for renewable energy plants, with a target to double cumulative lending to 15 billion euros between 2015 and 2020, predicted that projects would be subject to more conservative financing structures in the unsubsidized future. Mark Muldowney, managing director, energy and infrastructure for BNP Paribas, told BNEF in an interview: “There would be a squeeze on the average ratios that the banks have used in the past.” He added: “On the debt-equity ratio, this could fall from 80:20 to two-thirds-one-third, but it would be case by case.”

There would also be implications for the tenors on project finance loans, and for the pricing of that debt, he said. In the last year debt pricing has declined, but this trend could go into reverse as subsidies disappear. Muldowney reported that he is seeing more financing proposals crossing his desk from battery project developers: “To finance a battery project with debt, you would want a contracted revenue stream and you would not want to take much risk on the medium-term value of batteries.”

Read the Q&A below:

Q: What trends are you seeing in clean energy project finance at the moment?

A: This doesn’t feel like 2007 all over again. For instance, there hasn’t been an enormous return of the syndication market, which is what you would expect if things were getting very frothy.

There has not been an obvious move in debt-equity ratios in the last year, but pricing has drifted down gently, by 25 basis points or a little more. This reflects the fact that banks remain liquid and want to be involved in the renewable energy project finance market. The reduction has been across Europe, including the U.K., where we have not yet seen any Brexit issue for financing.

We are doubling our commitment to renewables over the next few years, with a target to increase cumulative exposure for BNP Paribas to 15 billion euros in 2020. There is still a lot of desire on the part of banks to be involved in this market, and interest from institutions to come into it. However, there will of course be new challenges in the unsubsidized era.

Q:How would you expect the project finance lending market to change as we move to an era of no subsidies?

A: If we are moving into a world of merchant deals or PPAs and no subsidies, there is likely to be a smaller pool of equity providers and fewer banks, and lower leverage.

The last time there was a lot of financing on a merchant basis was at the end of the last century, with combined-cycle gas turbine plants. That ended unhappily for a lot of investors and banks, because of a fall in electricity prices. I think there is enough collective memory in the banking market to avoid a rush into a large amount of merchant debt. For some renewable technologies, it should be a bit easier to get project finance on merchant deals than it is for CCGT plants, with their fuel cost uncertainties. If you have a wind or solar project and can fix the costs of production at a rate that is competitive with whatever the market can produce, you should be able to get some debt on a merchant basis, although it will be less than you got in the subsidized era.

For a merchant deal, in principle you would have more equity, and that would need to be coming from people who have a view on future power prices.

There would be a squeeze on the average ratios that the banks have used in the past. There is no shortage of banking capital at the moment, and this is now seen as a mature sector, but unsubsidized deals would be difficult for marginal lenders. On the debt-equity ratio, this could fall from 80:20 to two- thirds-one-third, but it would be case by case.

If you assume a debt service coverage ratio of 1.2 on P90 wind at the moment, then a move to 1.15 on P90 wind would help to sustain high gearing levels. But the history in the U.K. has been that coverage ratios on the merchant revenue elements of deals have actually risen sharply towards 1.7 to 1.8. You will also see an increase in bank margins as merchant risk rises, but for many lenders increased pricing will not be enough to compensate for greater risk. There might also be a move towards shorter tenors. For a wind or solar project that is unsubsidized but underpinned by some sort of PPA, similar considerations would apply. If the PPA was for just a short period, you would expect the banks to insist on much higher ratios for debt service, and some increase in margins also.

Q:One of the issues in terms of financing new projects is that it is difficult to hedge power prices out for more than a few years, so there is a lack of certainty on revenues – unless the developer has managed to negotiate a PPA with a corporate customer or a utility. Is there scope for new players to provide electricity price hedging instruments?

A: There is far less liquidity in the power hedging market than a few years ago. There used to be financial investors and utilities providing medium-term liquidity on power prices for a few years out. These markets are not liquid. Getting cover for more than three years out is very hard.

Utilities are the people who logically could provide the hedging, but the accounting treatment of long-term hedges is difficult. But they could provide floors, and that would be very helpful from a debt perspective. Then you can firm up transactions without taking strong views on the peaks.

Corporate PPAs could provide some of the long-term hedging of electricity prices for developers and their investors and banks. However, so far, corporate PPAs have been much more talked about than done. In the future, hedging is likely to come from a combination of utilities as the intermediating parties, and large electricity users. There is no sign of third parties such as the financial sector coming in to offer hedges on the power price.

Q:Are you seeing potential deals in ‘flexible capacity’ such as battery storage or gas-fired generation?

A: Quite a few battery deals are crossing my desk, but they tend to be quite small, at 20-40 million euros or so. They have gone for all-equity deals so far. To finance a battery project with debt, you would want a contracted revenue stream and you would not want to take much risk on the medium-term value of batteries. It would need a 4-5 year contract with the grid. Otherwise, it would be a speculative project, saying that at the moment it can sell frequency services to the grid. We wouldn’t back it on that basis.

In the U.K., you would expect to see more gas projects. Quite a lot of them have been developed, for instance by Americans interested in the sector, but it is difficult to get a lot of debt into these projects. Bidding in capacity market auctions has not favored new CCGT so far.

Q:There is quite a bit of talk at the moment about pumped hydro, with people proposing new ideas such as seawater pumped hydro or pumped hydro in disused coal mines. Would BNP Paribas be interested in helping to finance a pumped hydro project?

A: Pumped hydro projects were originally built in the U.K. to deal with a big shock such as the Sizewell nuclear plant going down. The idea was that they could provide electricity with just a few seconds’ notice. For us to lend to a pumped hydro project now, the question marks would be over the uncertainty of revenues and the length of time to build. They are like giant battery projects, so you would have to look at returns relative to the likely future costs of batteries. I suspect they would look quite expensive by comparison. If the grid is happy to contract for services from the pumped hydro project, then fine. But I think they would struggle to get finance if it was on a merchant power basis.

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